Review Of U.S. Small Caps – March 2017

Within U.S. small caps, the market appeared to be awfully quiet in March, with many investors sitting on the sidelines awaiting the much anticipated health care and tax reforms. Small caps returned a measly 0.1% for the month, in line with U.S. large caps. Large caps, boosted by performance in January and February, outpaced small caps by 3.6% in the first quarter. This was the sixth largest win ever recorded by large cap over small cap in the first quarter. After the stellar performance in large caps, small caps only trade at an 8% premium to large caps, down from the 15% premium at the end of January. The Russell 2000 Index (R2K) trades at a forward P/E of 19.0x, while the Russell 2000 Value Index (R2KV) and the Russell 2000 Growth Index (R2KG) trade at 17.7x and 20.8x, respectively.

After losing by a wide margin in 2016 to the R2KV, the R2KG posted three straight months of relative outperformance. Growth outperformed Value by more than 1.0% in each of these months, with March having the largest spread against Value at 2.1%. Growth beating Value was a trend across all size segments. The main two factors driving this spread were the performance in the fastest EPS growers and the strength from biotechs. Biotechs, an outsized industry weighting in the R2KG, returned 18.6% in Q1, almost erasing all of the losses incurred last year. Finally, when Value wins by such a large margin against Growth in the previous year, it tends to keep the momentum going forward into the new year, which has not been the case so far in 2017.

The first quarter has seen quite the reversal of sector performance when compared to last year. After a very difficult 2016, Health Care has gone from worst performing sector within small caps to the best. Health Care was driven higher by the performance in biotechs and the increased speculation of M&A activity with larger companies looking for inorganic growth in a muted environment. On the opposite end, Energy, one of the best performing sectors in 2016, was the worst performing sector in Q1. Speculation that non-OPEC countries will not hold up their end of the bargain and increased drilling from the higher-cost producing shale companies, capping oil prices, are culprits.

After seeing inflows of over $17.5B last year, small-cap ETF flows continued their momentum as we have seen inflows totaling $6B thus far in 2017, outpacing last year’s inflows year-to-date. With nearly 40% of these inflows occurring in March, the smallest market cap names outperformed during the month, though this was not the case for the entire year. The biggest winner for the month were the highest ROE and the lowest P/E names. For the year, the fastest EPS growers have performed quite well, piggybacking off biotech’s strength. Non-yielders performed very well during Q1, which was a trend across many asset sizes. Overall, lower-quality companies have led this early rally, with non-earners and the highly levered driving performance.

Active management by style performed well in the first quarter, with 54.0% of Value managers outperforming their benchmark. This was driven by managers being underweight the index in banks and Financials, which performed poorly, along with being in faster growing companies. Growth managers fared better, with 59.1% of managers beating their benchmark despite lower quality outperforming and biotechs, a perpetual underweight for Growth managers, driving returns.

Many of last year’s trends reversed in the first quarter, not only from a sector perspective, but also from a factor approach. The largest difference when compared to last year is the outperformance of the fastest EPS growers. This tends to bode well for active management as managers tend to invest in higher quality growth companies relative to the benchmark. In a quarter that saw $6B in small-cap ETF inflows, it is surprising to see that higher market cap companies have performed well thus far. This was not the case for March, as ETF inflows totaled $2.2B. Non-yielders outpaced yielders in March, and continue to lead by 1.5% for the year. This trend was apparent across all market cap sizes. Higher leverage performed poorly in March, but continues to have an outsized advantage over lower leverage in 2017. As we saw many different factors reverse their trend when compared to last year, non-earners have been the anomaly as they continued their momentum from 2016 and into Q1 2017.

Small caps are now trading at a forward multiple of 19.0x, which is 20.6% above the long-term average. At the end of January, small caps traded at a 15% valuation premium compared to large caps. With the recent relative strength in large cap performance, this valuation spread has decreased to 8%. This spread has historically been around 4%.

The R2KV’s forward P/E is no longer trading at an all-time high, but remains historically elevated at 17.7x. This is 31.5% above its long- term average. The R2KG trades at 20.8x, which is an 11% premium.

Russell 2000 Value Sector Performance

U.S. large caps have started the year strong, returning 6.1%, well above the 2.5% return for U.S. small caps. Outperforming by 3.6% in Q1, this was large cap’s sixth biggest margin of victory against small caps ever recored. The first quarter of 1999 holds the record as large outperformed small by a staggering 9.5%! Interestingly, when small lags large in Q1 and is more expensive than large, as we are seeing right now, small tends to catch up in the following nine months, ending the year even with large.

The average VIX level in Q1 was 11.69, which was the lowest Q1 on record and the second lowest for any quarter. It appears that there was lackluster volume as investors await clues about the prospects of passing numerous reform bills. The failure of the Republican party to pass a revised healthcare plan made tax reform more difficult. Failure to repeal Obamacare tax increases has resulted in a tax revenue baseline that is $1 trillion larger than the Republicans were expecting. This will force policymakers to look for other revenue offsets that were previously not considered. This caused skepticism with investors as it may take longer to pass reform than originally planned. Thus, banks took it on the chin in March, weighing down the Financials sector. Tax reform is one of the largest catalysts for banks, outside of deregulation.

After a strong rally against the R2KG in 2016, the R2KV quickly cooled as Value has underperformed Growth by 5.5% for the year. Growth has had tailwinds that it did not experience in 2016, i.e., outperformance in the fastest growers and the market-leading return of biotechs. Growth has a material overweight in biotechs versus Value’s nominal weighting, proving to be one of the main reasons for Growth’s outperformance.

In March, Health Care, which had a very strong January and February, cooled. The performance in Health Care can be attributed to the success of biotechs, even within Value. Biotechs, which at the end of February had already returned 12.9% within Value, slowed in March, declining 2.2%. Consumer Discretionary, which started the year off poorly as negative sentiment surrounded the retail industry as reports of store front overcapacity surfaced, coupled with the negative effects of a proposed border adjustment tax, led performance in March. Contrary to last year, Energy continued its slide, declining 3.2% during the month, now down 10.8% on the year. Financials declined much in part due to banks, which dropped precipitously at the end of the month. Increased speculation that it would take longer for President Trump to complete his promised deregulation and tax reform was the culprit. Historically, banks have had higher tax rates when compared to the market as a whole.

Health Care and Energy have been a tale of two years. Health Care was the worst performing sector in the R2KV for 2016, underperforming the benchmark by almost 27%, while Energy outperformed by 12%. So far in 2017, Health Care has been leading the charge, returning 9.1%, with Energy being the worst, declining 10.8%.

Active management by style performed relatively well in the first quarter, with 54.0% of Value managers outperforming their benchmark. This was driven by managers being underweight the index in banks and Financials, which performed poorly, along with being in faster growing companies. Growth managers also did well, with 59.1% of managers beating their benchmark despite lower quality outperforming and biotechs, a perpetual underweight for Growth managers, driving returns. On the other hand, core managers performed the worst out of the group, with only 33.3% of managers beating their benchmark.